Uncertainty, information and project evaluation

Abstract

This paper presents a practical method for project evaluation using techniques of financial economics which were developed originally for valuing stock options and other financial assets. It is based on the formulation and estimation of an "information model" which represents the resolution over time of uncertainties underlying a project. Cash flows can then be valued using techniques of derivative asset valuation. The method overcomes shortcomings of conventional methods which are either imprecise about the relation between economic value and uncertainty, or are rigid and unrealistic in the assumptions that must be made about this relation. For ease of implementation, the method has been designed to be as close as possible to approaches familiar in industry today. The formulation of decision alternatives, the selection of underlying uncertainties, and the design of a cash-flow model are essentially the same as in conventional discounted cash-flow methods, as are the simulation and valuation results. The information model also can be estimated using analysis and judgment similar to that applied in conventional evaluation. The approach is illustrated in application to an oil development project under a complex tax system, where oil prices are the underlying source of uncertainty.